Shareholders should beware of ‘empty voting’

In modern democracies, we've gotten away from the idea that you need to own property to vote. But in shareholder elections, tying votes to stock ownership is actually ideal – and when voting rights and economic interests suddenly get disconnected, other shareholders in the corporation can lose.

It doesn't seem to happen too often, but when it does, it can be a big deal, such as the 2012 squabble between Telus Corp. and Mason Capital Corp. that ended up in the courts. So before it happens too frequently and with greater consequences, the Canadian Coalition for Good Governance (CCCG) has issued a new position paper that calls on regulators and legislators to step up and be ready to respond to what's called "empty voting."

"If there's empty voting going on, the principles we've been fighting for, like majority voting, which we've been fighting for for 12 years, won't work properly," says Stephen Erlichman, the coalition's executive director. "This is our attempt to bring this to the attention of the securities regulators and the legislators, to say 'please look at this because we believe it's fundamentally wrong, even if it doesn't happen that often.'" And when it does happen, he adds, it will likely happen in a hard-fought matter: "If you had a 52-48 vote, it could well have been decided the other way if empty voting had been involved."

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How do voting rights and economic interests get separated? In the most simple example, it occurs when corporations have special classes of shares with extra voting rights, as many Toronto Stock Exchange-listed companies do. That's not what the coalition is targeting here, however; it's special circumstances where a shareholder has the right to vote when its economic incentives are different from the rest of the shareholders.

It can happen when an investor holds shares on the "record date" on which eligible voters are determined, sells them before the shareholder meeting, but still votes. The now former shareholder doesn't feel the effects of what comes next for the company, despite casting the ballot.

Or, in an even more complicated situation, it can happen when stockholders use financial derivatives to hedge or blunt their exposure to the shares they own, but then vote anyway. One example of a derivative is a "put option," which allows the holder to sell a stock at a certain price, within a specified time and protects the holder if the shares go down in price.

"Say that you have a hedge fund that owns a million shares, and it buys a limited number of put options on the shares, so in that circumstance it would be an empty voter because it would have a million votes, but its economic interest is not a million votes because of the put options it owns," says Henry T. C. Hu, a professor at the University of Texas School of Law who coined the "empty voting" term. "So in effect, the vote the hedge fund has is emptied of the corresponding economic interest."

And, Mr. Hu says, "If it buys a large enough number of put options its economic interest can become negative.

"In that circumstance, that hedge fund would actually have the incentive to vote in favour of decisions that would be harmful to the company because it stands to benefit from a drop in the price of the shares. So this type of extreme empty voter, one with negative economic ownership, is quite troublesome."

While these cases of empty voting are rare in Canada, they occur. In July, Fairfax Financial Holdings Ltd. sold 14.2 million shares in Tembec Inc. on the record date for a shareholder vote on a Tembec takeover offer by Rayonier Advanced Materials. Shareholders opposed to the Rayonier offer complained that Fairfax should not be allowed to vote and filed complaints with the Ontario Securities Commission and Quebec's Autorité des marches financiers.

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Fairfax, however, did not vote the shares. Says Paul Rivett, president of Fairfax: "Fairfax was never approached by the OSC and never has considered voting any share it has sold, including the Tembec shares. Fairfax firmly believes that only shares that are owned should be voted. Unfortunately, the activist shareholders in the Tembec/Rayonier transaction never gave Fairfax the courtesy of calling them before beginning a public debate on the matter."

The coalition's Mr. Erlichman says "Fairfax did the right thing and the honourable thing, because they'd sold them. We applaud them. But they had the legal right to vote them."

In perhaps the best-known and most controversial example of the practice, a U.S. investment firm, Mason Capital, acquired $2-billion of stock in Telus Capital in 2012 in advance of a planned collapse in the company's two-class share structure. Mason Capital argued the voting shares should get more of a premium in the Telus plan. But because Mason Capital has also shorted Telus shares – it had only a $25-million stake in the company – Telus argued in a legal dispute that ultimately went to the B.C. Supreme Court.

The Court of Appeal for British Columbia ruled in the case that "there is no indication that it [Mason] is violating any laws, nor is there any statutory provision that would allow the court to intervene on broad equitable grounds. To the extent that cases of 'empty voting' are subverting the goals of shareholder democracy, the remedy must lie in legislative and regulatory change." (The Supreme Court affirmed the ruling.)

With no change from those regulatory and legislative standpoints five years later, the coalition is taking up the cause more forcefully. The group believes empty voting should be illegal, but acknowledges "this goal is far from being a practical reality." In the interim, the coalition says, securities regulators should "use their discretion to act in the 'public interest' to restrict empty voting or empty voters where it is warranted" and also provide guidance as to the situations that will prompt them to act.

There is at least one example of action: In 2006, the Ontario Securities Commission cited its public-interest jurisdiction and blocked certain votes from being included in the tabulation of a shareholder vote on a buyout at Sears Canada.

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"We look forward to reviewing the recommendations in the CCGG report," says OSC spokeswoman Carolyn Shaw-Rimmington. "We recognize that the outcome of shareholder meetings should be determined by those with an economic interest in the matter. We recently updated our disclosure requirements to provide greater transparency about empty voting and, where appropriate, the Commission may also intervene on public interest grounds to address the impact of empty voting."

That, says Mr. Erlichman, is the kind of thing the coalition wants to see more often. "Say you'll take a position in the public interest and intervene if you see it happening."

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